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Sunday, June 5, 2011

The Unintelligent Investor's Definition of the Week: Liquidity

Oxford Dictionary definition: the availability of liquid assets to a market or company.
Definition of liquid assets: held in cash or easily converted into cash.

From Wikipedia, market liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash in hand is the most liquid asset.

The Unintelligent Investor’s explanation

From what I understand, when you say someone is liquid, you mean they have more cash in hand. Or when you say an asset is liquid, it probably means you can sell it or change it to cash easily and quickly.

From the definitions giving by Oxford dictionary and Wikipedia, they say liquid assets are assets like cash, which implies that they are illiquid assets as well i.e. property. So if you think about it as a scale, going from more liquid to less liquid, the order of assets will be something like:
Cash, different currencies, commodities, shares, properties

A lot of the time we think of assets as just assets and forget to remember that some are more liquid than others. Why is this important sometimes? I guess it comes into play when opportunity arises, good or bad. For example, the economy is doing badly, you can easily liquidate your shares and minimize your losses but can the same be said to your property portfolio? If you cannot find a buyer, and desperately need the cash, you will have to settle for a lower price or in the worst case scenario, be foreclosed. On the other hand, if a good business opportunity arises, do you have enough liquidity to invest in that business?

Moreover, different shares have different liquidity as well. Blue chips tend to be more liquid than small caps and that is something we have to think about as well. What if we make a big paper profit on some small caps and cant find a buyer when we want to liquidate? Remember that when we look at our portfolio on our online broker, the profit is counted by looking at the last price but what is the market depth, volume traded and what is the next asking price? We might not be able to sell at the last price. So we should probably remember to look at the other parameters as well.

Another thing that I think about when we talk about liquidity is in relation to companies and their assets. A company needs cash flow to fund their day to day operations. If they don’t have enough cash flow they either have to hunt down their debtors, get more credit, raise capital or liquidate some of their assets. So if the company has highly illiquid assets, they might get into trouble when for whatever reason, they need to raise cash. So when looking at a company’s accounts, remember to note their long and short term assets as well as their cash flow. If they have millions in receivables but almost zero cash flow, it might not be a good thing.

Probably somebody who is doing accounting or is an accountant can comment further or correct whatever I said wrongly. Accountants out there please don’t laugh at my amateurish post lol. Thanks for reading! Do drop me comments or send me emails, I really appreciate them.